Dividends and a Sea Change in Corporate Behaviour Toward Shareholders

In today's Daily Reckoning we again take up the issue of dividends and whether we're on the brink of a sea change in corporate behaviour toward shareholders. But before we get to that there is some news to deal with.

First up is an issue that definitely affects the future of Aussie dividends: profits. You can't pay 'em out if you don't got 'em (unless you borrow 'em, which is just plain stupid). "Profit season looming as worst for 20 years," reports Lucy Battersby in today's Age. She says that analysts expect profits to be twenty percent lower than last year with "growth prospects" pretty dismal.

Maybe we're getting ahead of ourselves with the idea that Aussie companies will begin boosting dividends to attract shareholders. After all, Bloomberg reports that Aussie firms tapped the equity markets for over $90 billion in capital in the last fiscal year. It's what you do when you're rebuilding your balance sheet and paring back debt.

In fact, RBA Governor Glenn Stevens-in addition to letting everyone one know the cash rate would remain at a 49-year low of three percent-encouraged corporate Australia to boost the stability of the financial system by bolstering balance sheets (more capital, less debt). Stevens said yesterday that, "While the considerable economic policy stimulus in train around the world should support recovery, it is likely to be slow at first. For it to be durable, continued progress in restoring balance sheets is essential."

What does that mean, though? Well in the long-run it's very good! In the short-run, it means slower growth and less business investment (capital spending). That probably means either increased unemployment, or much slower growth in employment, which puts pressure on wages (not that their moving up much anyway).

Here's a story commodity punters should keep an eye. The U.S. Commodities Futures Trading Commission is thinking about new regulations that limit positions sizes on commodities contracts. The agency says it wants to reduce "excessive speculation" in the commodity markets, especially the oil market. The agency will hold hearings in August.

Well, one way of looking at oil's rise to $147 is that it was all a beat up engineered by Goldman Sachs. That's what Matt Taibbi says in his latest Rolling Stone article, "The Great American Bubble Machine." It's a claim that the oil market is heavily manipulated by speculators and that the price of oil is divorced from the laws of supply and demand in the real economy.

Taibbi's piece is worth a read. But the CFTC is barking up the wrong tree if it wants to blame high energy prices entirely on speculators. One factor in oil's rise is clearly investment demand from traders and institutions that foresee the decline of the U.S. dollar. Another factor-subject to much debate-is Peak Oil itself (that global oil production is peaking). More on that tomorrow.

For now, we'd say this is another sign of increasing government control of the markets. Some people think this is good and long overdue. Some people don't. Either way, it looks like the world we're headed to. And it looks to us like a sure sign that the U.S. government wants to have a lot more control of what you do with your money (capital controls). We reckon the oil trading will just move to London.

More about dividends. Today's Financial Review reports that Aussie investors may miss out on $7 billion in dividends this year. The report cites research from Macquarie Securities which shows that Aussie companies paid out $48.6 billion in dividends last year but are on pace to pay out just $41.5 billion this year. Companies are preserving capital.

Again, we're not sure this is a bad thing. But it does mean that if you pursue a dividend strategy, you may have to look beyond traditional sources (banks) and do your homework. We've got Kris Sayce in the trenches doing just this work now and will report on it later this month. But what else might this renewed focus on dividends mean?

Well, it might mean the debauched age of capitalism-where companies borrowed money to speculate or invest in projects for which there was no sustainable demand-is well and truly over. It might mean companies will go back to returning earnings that are not reinvested to shareholders, where they belong.

Of course, for a company to return surplus earnings back to investors it must first have those earnings. And that is no mean feat in the post-industrial global economy. So rather than relying on the market itself to generate your dividend income for you, you'll probably have to work for it (find it).

And there is the risk that common stocks may simply be the wrong asset class to own for the next ten years. That is, there is the risk that even dividend stocks are still stocks. And if stocks are in secular bear market, it won't matter how much you get paid to own them. They will appreciate very slowly, and perhaps not at all versus inflation.

And now to debt. We've run across a few articles and charts on debt that were eye-opening. Speaking of which, please keep an eye out later today for a special invitation to an event we're putting on here in Melbourne. It will be a night dedicated to discussing this very subject.

And the main point? Not only are large (and growing) household and government debt levels making life tough for Aussies, they are part of a global power shift that threatens the economic security of industrial countries like Australia. Despite its tremendous resource wealth and proximity to developing giants India and China, Australia risks drowning itself in debt.

Or, as James G. Neuger writes for Bloomberg on the eve of the G-8 summit in Italy, "The run-up in debt has hastened a power shift that is sapping the industrial world's authority to impose its economic doctrine, currency arrangements, or greenhouse gas reduction strategies. Even some G-8 officials acknowledge that the group has lost its grip on the global recession they spawned."

"The industrial world is beset by the harshest economic conditions in a lifetime: a projected U.S. budget deficit of 13.6 percent of GDP in 2009, unmatched since World War II; an annualised 14.2 percent contraction in Japanese GDP in the first quarter, also the worst since the war; in the first three months of 2009, German exports had their steepest quarterly decline since 1970 when the date were first compiled."

But is debt really a problem here in Australia? The chart below from the Bank of International Settlements (BIS) shows that it is, and a big one at that. Australian households have the highest household debt to disposable income ratios in the world, according to the BIS. Most of household debt, of course, is mortgage debt. And households are happy to take on mortgage debt as long as house prices are rising, interest rates are low, and the job market is good.

But as you can see, in markets where interest rates have risen and house prices have fallen, households have already begun seriously deleveraging, repairing their balance sheets by saving more and spending less and relying on asset appreciating a lot less. This process-as much psychological as financial-has yet to happen in Australia. We believe it will (it's one of the things we're going to discuss at the Debt Summit.)

But debt is not just a household issue. It's a pension issue too. That's because Australia has a huge portion of its pension assets in stocks. And as the world economy deleverages, assets bought with borrowed money are sold or revalued. For Australians, that means a huge write down in the value of assets held by pension funds.

Check out the chart below from the International Monetary Fund (IMF). It shows that Australia's pension assets (mostly superannuation funds) are not only about 100% of GDP (or nearly $1 trillion), it shows that the bulk of those assets are not diversified at all. Most of it's in stocks. The rest is in property (a highly leveraged sector arguable even more vulnerable to deleveraging).

What does the chart really mean? It means that it's time for a serious rethink of how you manage your retirement assets. Super...stocks...porperty...how you make, keep, and grow your wealth is a serious challenge for the future. And the accumulation of vast household, corporate, and government debt is making it even more challenging.

In fact, government debt may be the other shoe to drop. We won't get into too much detail. But we'd suggest that Australia is treading down the path to where questions about the quality of its bonds-or worst case, its fiscal solvency itself-might start to be asked.

Granted, the public debt-to-GDP ratios in Australia are modest compared to the U.S. and the U.K. And even if they grow to around 16% of GDP (as the IMF suggests they will), they will still be much lower than other places around the world. But it's the casual attitude toward accruing these long-term liabilities that worries us. And it's also the affect rising public debt has on interest rates.

The IMF puts it this way: "Doubts about fiscal solvency-the risk that governments find it more convenient to repudiate their debt or to inflate it away-could lead to an increase in the cost of borrowing. In turn, higher interest rates (and exchange rate depreciations, particularly in countries with significant borrowing in foreign currency, like most emerging economies) could further add to government debts-in some cases, resulting in 'snowballing' debt dynamics. This scenario would be deleterious for global growth."

Yes, it would be bad for growth. And a 2003 study from the Federal Reserve (cited yesterday in the Times of London) says it would also be bad for interest rates. The study concludes that "a percentage point increase in the projected deficit-to-GDP ratio raises the 10-year bond rate expected to prevail five years into the future by 20 to 40 basis points; a typical estimate is about 25 basis points."

It was referring to increased borrowing costs for the U.S. government because of rising deficit-to-GDP ratios. But in the current Credit Depression, we have no reason to believe Aussie borrowing costs wouldn't rise too with rising deficit-to-GDP ratios.

"All else equal," study author Thomas Laubach concludes, "The results of this study suggest that interest rates rise by about 25 basis points in response to a percentage point increase in the projected de_cit-to-GDP ratio, and by about 4 basis points in response to a percentage point increase in the projected debt-to-GDP ratio."

And what does it mean? "The impact would be devastating by making it punitively expensive to finance national borrowings and leading to what Tim Congdon, founder of Lombard Street Research called a 'debt explosion.' Mr. Congdon said the study illustrated the 'horrifying' consequences for leading Western economies of bailing out their banks and attempting to stimulate markets by cutting taxes and boosting public spending. He said the markets had failed to digest fully the scale of fiscal largesse."

To be sure, if the cost of refinancing public debt doubles, it's going to be particularly nasty for the U.S. and the U.K., where public debt to GDP ratios are on the rise. But what would it mean for Australia, where public debt to GDP would be smaller, but a lot larger than it is today? Stay tuned...

Dan Denning
for The Daily Reckoning Australia

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